Part 5: A Primer on Fundamental Analysis
Introduction to Fundamental Analysis
In the previous post in this Beginner Guide to Stock Investing, we discussed how individual investors have several key advantages over professional money managers, while also recognizing the key skills, time commitment, and behavioral traits needed to be a successful, long-term stock investor. In this post, we’ll look at the process that serious investors use to investigate individual stocks. This process is broadly known as fundamental analysis.
This concept is part of a broader framework known as fundamental investing.
What Is Fundamental Analysis?
Fundamental analysis is a framework for researching individual stocks. The fundamental analysis framework focuses on the earnings power (i.e., ability to generate long-term cash flows) of the underlying business, the many factors that support that earnings power, and the appropriate price for these earnings.
Fundamental analysis is the key to separating prudent long-term investing from more speculative approaches. In his seminal 1934 book Security Analysis, Ben Graham, considered by many to be the father of fundamental stock analysis, distinguished the terms investment and speculation as follows:
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
Ben Graham
With this definition in mind, we can say that fundamental analysis is a prerequisite for directly investing in stocks.
The Two Phases of Fundamental Analysis
The fundamental analysis research framework broadly consists of the following phases:
- Studying the underlying business
- Calculating a conservative per-share value and comparing the estimated value to the current stock price
Studying the Underlying Business
Because stock investors view a stock as a piece of a business, the first step in the fundamental analysis framework is to thoroughly study the underlying business.
This phase of the research process relies on both qualitative and quantitative research.
Qualitative Research: Understanding the Business
Some of the qualitative questions that investors try to answer are:
- How does the company make money?
- Who are its customers?
- Are the customers loyal to the company?
- What makes the customers choose this company’s offerings over other offerings?
- Who are its key competitors?
- Who are its managers and how are they compensated?
- Does the company have a culture that demands and encourages ethical behavior from its employees?
- Is there significant employee turnover? If so, why?
These and other qualitative considerations can come from a variety of sources. Some of this information can come from the company itself, and some of this information can come from industry publications and other news sources. Investors can do a significant amount of this research by searching the internet and talking to industry sources.
Quantitative Research: Financial Statement Analysis
Most of the quantitative analysis will come from the company’s financial statements as presented in the company’s filings with the Securities and Exchange Commission (SEC). Investors rely heavily on two key filings: the annual 10-K filing and the quarterly 10-Q filing.
Financial statements are the primary means by which companies communicate their operating results and financial position to their investors. The ability to read and interpret financial statements is one of the most important skills that investors can have.
If you’d like to learn more about how to read balance sheets, income statements, and cash flow statements, these topics are covered in depth in the Understanding Financial Statements course at the Fundamental Investing Institute.
Companies listed in the United States must prepare their financial statements in accordance with a set of rules known as Generally Accepted Accounting Principles (GAAP). Investors must familiarize themselves with these rules and how companies use them to prepare their financials.
The Three Core Financial Statements
The key financial statements are the balance sheet, the income statement, and the cash flow statement. None of these statements provide a complete picture of a company’s finances. Rather, investors must pull information from all three statements.
Understanding the Balance Sheet
The balance sheet is a snapshot of the company’s financial position. It consists of three sections: assets, liabilities, and equity.
Assets are resources that a company controls. Assets are expected to provide the company with future economic benefits, and they are presented on the balance sheet in the order of liquidity – i.e., how quickly the asset can be converted to cash. Thus, cash is the first item in the asset section followed by other liquid assets. Assets which are expected to be converted into cash within one year from the balance sheet date are called current assets. Current assets are presented on the balance sheet before long-term assets, such as real estate and machinery.
Liabilities are obligations the company has to creditors, suppliers, the company’s employees, or other stakeholders. While most of these obligations need to be settled in cash, some obligations require performance of work or delivery of goods. For example, if a construction company receives an upfront payment from a customer, that payment is a liability until the work is performed. Liabilities are presented on the balance sheet in order of the time expected to settle the liability. Liabilities that are expected to be settled within one year from the balance sheet date are called current liabilities. Current liabilities are presented on the balance sheet before long-term liabilities, such as long-term bank debt.
The final section of the balance is shareholders’ equity, and it represents the residual claim that shareholders have on the company’s assets. Shareholders’ equity primarily consists of capital that the company’s owners have invested in the company plus net profits retained in the business.
Because liabilities and equity represent claims on the company’s assets, the sum of liabilities and equity must equal assets. In other words, both sides of the balance sheet must “balance.”
Although the importance of the balance sheet varies by company, the balance sheet provides investors with two key pieces of information. First, it indicates how much capital has been invested in the company. And second, it indicates the company’s capital structure. The capital structure is the mix of debt and equity that the company uses to finance its business.
Understanding the Income Statement
The second major financial statement is the income statement. The income statement summarizes the firm’s operating activity over a period, such as a quarter or a year.
The main components of the income statement are revenues, expenses, gains, and losses.
Accounting rules require that companies recognize revenue and expenses on an accrual basis, meaning that revenues and expenses do not directly correspond to cash flows. Rather, the income statement shows flows of value (transactions that increase or decrease the worth of the company).
Revenues are sales made to customers and represent inflows of value to the firm. Expenses represent value consumed in the period in the process of generating the associated revenue.
Gains and losses relate to the sale of long-term assets, such as vehicles, real estate, or machinery. When a company sells an asset for more than the asset’s balance sheet value, it records a gain. When a company sells an asset for less than the asset’s balance sheet value, it records a loss. Gains and losses are not considered income from core operations, so they are shown as a separate line item on the income statement or aggregated with other nonoperating items. Gains and losses, like revenues and expenses, do not necessarily correlate with cash flows.
The last line on the income statement is net income, and it represents the sum of all the items (positive and negative value flows) on the income statement.
When reading the income statement, investors are primarily concerned with operating profit. This profit subtotal excludes items not directly associated with the company’s core business activities and thus represents the most sustainable source of current and future profits.
Understanding the Cash Flow Statement
As mentioned above, the income statement captures flows of value rather than flows of cash. To understand how cash has flowed in and out of a business during an accounting period, investors turn to the cash flow statement.
The cash flow statement “explains” the change in the company’s cash assets from the beginning of an accounting period to the end of the same period. The statement separates cash activity – i.e., sources and uses of cash – into three categories: Cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities.
As with profits, investors are most concerned with sustainable sources of cash flow. This leads investors to focus mostly on the cash flows from operating activities section of the cash flow statement. However, the investing and financing sections of the cash flow statement provide important information to investors regarding these business activities.
Important Disclosures: Footnotes and Management Discussion
Companies must provide footnote disclosures to their financial statements in both quarterly and yearly reports. These disclosures are many pages longer than the financial statements themselves and provide highly important information that is not explicitly shown on the financial statements. Investors must read these notes with a critical eye.
Another important source of information to supplement the financial statement is the management’s discussion and analysis section of the annual report. In this section, the company’s management discloses important information regarding any major expenditures and strategic decisions made over the previous year.
Estimating the Value of a Stock
The second phase in the analysis is to estimate the per-share stock value. The valuation is the basis for the investment decision and is the culmination of all the previous work the investor has done on the company. Stock valuation is at the heart of fundamentals-based stock research.
Although there are numerous methods to value a business and its equity, the two most common are the comparables method and the discounted cash flows method.
The Comparables Valuation Method
The comparables method relies on comparing market valuation multiples of the company being studied against market valuation multiples of similar public companies. The theory behind the comparables approach is that similar companies should trade at similar valuation multiples.
Valuation multiples are ratios that compare a measure of market price in the numerator with a measure of earnings or book value in the denominator. There are many different valuation multiples that investors can use, but the two most common ones are the price-to-earnings ratio and the enterprise value-to-EBITDA ratio.
The price-to-earnings (PE) ratio compares the current stock price to the most recent twelve months of earnings-per-share. The PE ratio indicates the price that the public market is placing on each dollar of current earnings.
The enterprise value-to-EBITDA ratio compares the company’s total market value (market value of equity plus market value of debt) to earnings before interest, taxes, depreciation, and amortization (EBITDA). Because EBITDA excludes interest cost, taxes, and depreciation and amortization (which are non-cash), it allows for better comparison among companies with different capital structures and depreciation policies.
The Discounted Cash Flow Method
The discounted cash flow (DCF) method involves estimating future discretionary cash flows and discounting those cash flows to the present using an appropriate discount rate. There are variations of this method, but one common method involves calculating per-share stock value using the following steps:
- Projecting future discretionary cash flows available to both debt and equity holders.
- Calculating the value of the entire business by discounting those cash flows to today’s dollars using a discount rate that reflects the cost of both debt and equity capital.
- Calculating total equity value by subtracting all non-equity claims from the result of the previous step.
- Dividing the total equity value by the number of shares outstanding.
Both valuation methods have advantages and disadvantages. Investors understand that stock valuation is more art than science and can at best yield acceptable approximations of value. Investors usually calculate a range of values for the stock using both methods and various assumptions in each method. Investors can then use the average or median of the valuation range as their per-share value.
Margin of Safety
Investors then compare the per-share value to the current stock price. What investors are looking for is a current stock price that is materially less than the estimated per-share value. This discount offers investors a margin-of-safety that can increase the return and lessen the risk of a common stock investment.
Concluding thoughts
The above discussion is a broad introduction to the process of fundamental stock analysis. Analyzing a business is a skill like any other. The investor’s skill as a business analyst should improve over time. Investors get better at analyzing businesses by analyzing businesses. For beginner investors, the goal of studying businesses is to build what famed investor Warren Buffett calls a circle of competence.
A circle of competence is an in-depth understanding of the industry’s economics that allows an investor to make a reasonable earnings forecast. Investors build their circle of competence over time as they study more businesses. The prospects for most businesses will be too uncertain for investors to make a reliable forecast. Investors are OK with this reality and recognize that only a handful of good investment ideas are needed to generate meaningful returns.
Beginner’s Guide to Stock Investing Series
In earlier posts in this series, we discussed what a stock represents, how the stock market works, and how investors buy and sell stocks.
Part 1 – What Is a Stock?
Part 2 – What Is the Stock Market?
Part 3 –How to Buy and Sell Stocks?
Part 4 –Investing in Individual Stocks
Summary
Fundamental analysis is the process investors use to study individual businesses and estimate their long-term value. Rather than focusing on short-term price movements, the framework emphasizes understanding how a company generates earnings and cash flows and determining what those earnings are worth.
The process typically involves two major phases. First, investors study the underlying business through qualitative research and financial statement analysis. This includes examining the company’s industry, competitive position, management incentives, and the information contained in the balance sheet, income statement, and cash flow statement.
Second, investors estimate the value of the business and its equity using valuation methods such as comparable company analysis or discounted cash flow analysis. Because valuation involves uncertainty, investors usually calculate a range of possible values rather than relying on a single estimate.
By comparing this estimated value with the current market price, investors can determine whether a stock offers a sufficient margin of safety. Over time, the process of studying businesses also helps investors develop what Warren Buffett calls a “circle of competence,” allowing them to focus on industries they understand well.
Key Takeaways
- Fundamental analysis is the process of evaluating a company’s earnings power and estimating its intrinsic value.
- The framework typically includes two phases: studying the underlying business and estimating the company’s per-share value.
- Investors analyze both qualitative factors (industry, competition, management) and quantitative information from financial statements.
- The three primary financial statements used in analysis are the balance sheet, income statement, and cash flow statement.
- Investors commonly estimate value using comparable company analysis and discounted cash flow analysis.
- Successful investors look for stocks trading below their estimated value to create a margin of safety.
- Over time, studying businesses helps investors develop a circle of competence within industries they understand well.
